Wednesday, December 10, 2014

On a price only basis the S&P 500 Index is down 3.86% from the high reached on December 5, 2014 and headlines describe this recent market action as a "rout" or a market "tumble." I do not intend to pick on the publishes of the below headlines as many articles have highlighted the recent market action in this way.

These dramatic headlines can cause investors to loss sight of the real market action, and more importantly, the potential direction of the market as one looks ahead. I would not argue with the fact that one market sector has "tumbled," the energy sector. Other than the energy and telecom sector, investors have enjoyed respectable returns to date in 2014. Also, the S&P 500 Index remains up 11.8% in 2014 through today's close. This double digit return is on top of the 32+% return for the S&P 500 Index in 2013.

Below is a weekly chart of the S&P 500 Index. As evidenced by the chart, until this week, the S&P 500 Index has closed up for seven consecutive weeks. One fact that is a given is the market will not move higher every week of the year.

As 2014 is rapidly nearing a close, investors should be evaluating the catalyst for this recent pullback as we are at HORAN. The main factor that seems to have caused the recent decline is the decline in oil prices. An obvious question investors may have is what industries and market segments benefit from the decline in oil prices. Sector beneficiaries that rise to the top are some types of retail as consumers have more cash to spend, trucking, rail and airlines. As we have pointed out to clients we have met with recently, we think the oversupply of oil is only one factor. We also believe the demand side of oil is contributing to the decline in oil prices. In a recently released 100 page report by OPEC, it is noted that OPEC is also projecting a decline in oil demand in 2015 as can be seen in the below table taken from the report.

The slowdown in the emerging markets, especially in China, and the weaker economies in the eurozone and Japan all contribute to the reduction in the demand for oil. For now the U.S. economy seems to have disconnected from economies outside its borders and continues its "bump along" growth pace. Is this sustainable in the face of a broader economic slowdown?

At the beginning of 2014 most strategist believed long bonds would not be a good investment as interest rates were expected to rise. Rates have actually declined and the iShare 20+ Year Treasury Bond ETF (TLT) is up over 20%. Many strategist believed Europe was turning the corner and this would be reflected in positive relative equity prices in 2014. The opposite has actually occurred. Now some believe most of the bad news is priced into eurozone equties (Time to overweight eurozone stocks? by Jim Paulsen, Ph.D of Wells Capital Management) so is it time to allocate investments there?

In short, the recent equity market pullback is not a significant one. Could the decline materialize into a larger one? Most certainly. At the moment we do believe the U.S. economy will be a net beneficiary of lower oil prices. Some sectors that should benefit from lower oil prices, like the rails, have pulled back subsequent to the spike they enjoyed when the oil price decline began to accelerate as can be seen in the chart below. The advice for investors is if they are trying to buy the dips, understand why a stock or sector has declined.

Other market segments such as energy MLPs have pulled back as well. Some believe this is a direct result of the decline in oil. Some MLPs, for example pipelines, are not directly impacted by oil price movements since pipeline MLPs generally get paid based on the volume of oil that runs through the pipeline. However, if demand is lower, volume could be less for sure. thus negatively impacting earnings.

We also believe there is a political factor impacting MLP prices. Incoming House Ways and Means Committee Chairman Paul Ryan desires to overhaul business taxes in 2015. As reported by the Wall Street Journal, Ryan has indicated he wants to see changes to those companies and partnerships that are structured in a way they pay individual income taxes instead of corporate taxes. To us this sounds like a potentially negative tax impact for MLPs, REITs and S-Corporations. The point for investors is MLPs may be down in price for more reasons than simply oil related ones so do not buy the dips blindly.

In conclusion, this current pullback may not be at an end; however, looking out to 2015, we do believe equities will provide investors with positive returns. A recent report from Charles Schwab, Why Global Economic Policy Is Likely to Boost Growth in 2015, provides a positive perspective on the fiscal and monetary policies around the globe and how the 2015 policy can benefit specific global regions. Improved global growth would certainly be a positive for equity prices.

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